Bitcoin: Know the risks before investing

If I were to converse with somebody who manages a water purification factory, I would expect that individual to have a near expert-level understanding of the facility’s inner workings. I’d assume that they could explain the water purification process, the chemical change that takes place, and perhaps the difference in overall purity before and after. My rationale for the assumption is simple. I assume that this individual has invested time and energy into perfecting this process and has acquired some level of expertise as a result.

This isn’t unlike the assumptions I make when I learn that an individual has made a significant investment in a publicly traded company. In those cases, I assume that the individual has done their homework in order to become exceedingly familiar with company and confident in its future before exchanging their hard-earned dollars for shares of company stock.

At least, that would seem to be the logical course of action before making a significant investment, right? But, as you know, people are not entirely rationale (or patient enough to do their due diligence). Rationality and patience tend to go out the window when a “get rich quick” opportunity appears.

For example, look no further than the recent and ongoing Bitcoin and cryptocurrency bonanza. I wonder how many investors really understand what Bitcoin is. Let’s take a look.

Do Bitcoin Investors Actually Understand What They’re Investing In?

In the world of investing, understanding what makes a company tick is important. This is because the more an investor pool is represented by folks who don’t understand their investment, the more volatile the investment will be.

Think of it like this: Imagine if a thousand people dated a partner knowing nothing more than what their partner looked like and two random facts about their lifestyle. With so many unknowns about their partner, you probably wouldn’t predict that many of those 1,000 relationships would be successful. On the contrary, you’d expect most of those relationships would be instable and highly volatile. After all, neither partner knows much about the other, so when things get rough it’s easy justify moving on to the next suitor.

This is the future that seems likely for the cryptocurrency world. Here’s why:

By 2018, roughly one-third of millennials will be invested in Bitcoin. Of 1,000 Bitcoin investors surveyed, nearly one-third stated that they invested either to achieve easy profits or because friends or family members convinced them to do so. Just 40% of the investors surveyed stated they invested because they believe the technology is world changing. If we generously estimate that 75% of this cohort truly grasps the functionality and complexities of Bitcoin, then that would mean that only one-third of all Bitcoin have at least a high-level understanding of the cryptocurrency. Furthermore, only one in five Bitcoin investors plans to hold the investment for seven years or more. 80% of Bitcoin investors intend to sell their investment within six years.

Conclusion: A large percentage of Bitcoin investors are millennials who do not intend to maintain their holdings for the long-run. This get rich quick mentality likely explains why many, if not most, Bitcoin investors don’t really understand what Bitcoin is or how cryptocurrencies work.

What is Bitcoin?

Bitcoin was established in 2008 by creator Satoshi Nakamoto (pseudonym), after a proof of concept outline was created. The roots of this creation are somewhat mysterious as the founder’s true identity has never been confirmed.

Bitcoin’s most simplified mission statement would seem to be to “eliminate the middleman in financial transactions.” In the proof of concept model, Nakamoto discusses that society epidemically relies on third-party banking institutions to process electronic payments. In his eyes, this is a problem because it perpetuates non-reversible transactions that financial institutions must mediate and expend resources to facilitate. Banks and other financial institutions pass these expenses along to buyers and sellers. The Bitcoin system attempts to eliminate these costs by offering a method that eliminates the middle man and increases the speed of transactions.

How does Bitcoin work?

In the Bitcoin world, individuals own electronic coins that they can transfer to others. The electronic coin is signed over to the new individual within an entirely public transaction that keeps record of the ownership history of the coins. On top of historically recorded names of coin owners, the public Bitcoin ledger timestamps every transaction.

Transactions can be peer-to-peer, business-to-business, or person-to-business. In every transaction though, Bitcoin maintains that no third-party will ever be interwoven as mediator. By keeping a vast amount of public knowledge available on the electronic coins it aims to avoid coins being double spent without the receiver’s knowledge.

Though there is a high degree of public information logged, Bitcoins strives to provide complete anonymity for parties involved. Nakamoto’s original guidelines proposed that individuals would hold a public key which are much like cyber ID cards that are linked to us. These public keys do not have to contain anything that publicly links the key to the keyholder’s real identity.

How is it being used today?

At this time, Bitcoin is a semi-functional form of currency. Many companies see adopting Bitcoin as a way to target technically inclined areas of the market that may show favor to their business because of the use of cryptocurrency.

For instance, Dell now accepts Bitcoin payments for online purchases. Dell hopes not only to attract technically-inclined individuals to their company, but they also hope to improve their bottom line. The year before Dell began accepting Bitcoin payments, they incurred credit card transactions fees of roughly 2.75%. Hypothetically speaking, if Dell were able to convert all their transactions to Bitcoin they would save approximately $1.6 billion in banking service fees.

In an effort to make Bitcoin exchange more readily available to the public, countries like Greece are beginning to introduce Bitcoin ATMs throughout the country.

The growing acceptance of Bitcoin could be viewed as validation of the new currency. But, in some ways it could also point to desperation on the part of the businesses. For instance, companies like Air Lithuania briefly accepted Bitcoin as payment for flights before going bankrupt the next year.

There are hundreds of other examples of small businesses accepting Bitcoin. In many cases the decision appears to have been a Hail Mary attempt to turn their business around on the momentum of a novel currency rather than an endorsement of a superior form of currency or transacting business. There’s no doubt, Bitcoin is a very popular investment right now. That’s why there are plenty of businesses that are eager to associate themselves with Bitcoin’s popularity. Seemingly though, many of these associations are not based on pure belief in the Bitcoin currency system.

Problems with Bitcoin

Bitcoin is not without flaws. It has problems both as an investment and as a legitimate form of currency. As an actual currency, Bitcoin is far too volatile to be considered a sound means for daily transactions.

The second issue I see with Bitcoin is that the paradigm might be faulty. Irreversible transactions can reduce mediation costs that banks, credit card companies, and other financial institutions charge consumers, but the involvement of those intermediaries tends to reduce the risks associated with online transactions.

When we make purchases with credit cards we are using house money. Credit card companies will go to great lengths to protect their funds. Similarly, banks will protect their money which in turn protects you the consumer. Without this balance, it raises concerns of consumer protections in the Bitcoin world. In the Bitcoin arena many speculators already predict that Bitcoin will eventually have to formulate organized bodies of individuals who will assume a consumer protection type role. It seems likely that there will be a need to police Bitcoin activity, and when that occurs it seems probable that those costs will be passed along to consumers.

Bitcoin as an Investment

Though Bitcoin is a very popular digital currency at the moment, I have a fair amount of concerns about the currency as an investment. Billionaire investor Ken Fisher contends that the price of something on the market reflects 3-30 months of available opinions, information, and insight. Issues that may affect a company, but are not relevant until three years from now will likely have little influence on the share price.

In the case of Bitcoin, there are a plethora of issues that I foresee arising within the in the next two to five years. These issues would largely not be reflected in the current trade price but could have a tremendous impact on the long-term value of Bitcoin and other cryptocurrencies down the road.

Other countries are going through similar processes at this time as well. China recently outlawed cryptocurrencies and over the next 3-6 years additional legislation will follow that could dramatically affect Bitcoin’s popularity (and value).

The banking system and large companies could also impact the value of the currency. If several large companies (e.g., Amazon) reject Bitcoin or cryptocurrency in general that alone could be the difference between one Bitcoin being valued at $20,000 or $0. Along those same lines, say China or the United States outlaw cryptocurrencies. Those countries comprise roughly 37% of the world’s economy. That would mean that over one-third of the world’s economy would be mostly removed from the cryptocurrency equation.

Unsystematic Risk

Bitcoin is exposed to unsystematic risks that most other industries need not concern themselves with. Regulatory changes, diffused monopolization, and media confidence are all huge unsystematic risks that Bitcoin faces.

While Ford Motor Company may see profits cut if environmental regulations are sharpened, most investors would likely remain optimistic that the brand will persevere through the adversity. However, if the United States completely banned Ford vehicles then the problem would be much more severe.

Currently, media analysts contend that Bitcoin has a quasi-monopoly on the crypto market. Support and momentum for any one of the hundreds (thousands?) of cryptocurrency competitors could slash the per coin value of Bitcoin. While having a near monopoly at the start of the digital currency push has been a catalyst in skyrocketing Bitcoin’s value, it also acts as an extreme flag of caution.

Finally, it is worth mentioning that Bitcoins have no intrinsic value. So therefore, the value is only as good as the confidence that the media and consumers have in it. While Bitcoin already survived a brutal 2014 security compromise without seeing their name ruined, there no doubt will be unique events that will test the consumer confidence in the currency. Pairing this risk with emerging competitors and potential regulatory issues could results in a sharp halt to the dominant momentum we’ve seen over the last few years.

A Few Final Thoughts

Bitcoin’s abstract and cutting-edge nature makes it feel destined for continued volatility, which could go any direction – positive or negative. Many investors have been tantalized by the quick investment returns and prophetic claims as to a future guided by Bitcoin. While widespread ignorance and fickle investors are recipes for volatile forecast, regulatory questions and digital competitors may provide an even stronger reason to proceed with caution.

The monetary issues that Bitcoin hopes to fix may be resolved, but not without creating new problems that the world has never addressed. Based on the overall landscape I wouldn’t currently recommend investing in Bitcoin unless you have viable rationale that mitigates the possibility of the barriers to entry that I outlined above. In general, I’m extremely hesitant to recommend investing more than 5-10% of your portfolio in individual stocks. And given the uncertainty of Bitcoin and cryptocurrencies, I know I’ll be sticking with diverse mutual funds and letting others enjoy the stressful gamble.

WHAT'S YOUR PLAN FOR FINANCIAL FREEDOM?

Thousands of people are already using TDB to improve their finances. Why not join the community and learn how to get more from your money?

We hate spam. Your email address will not be sold or shared with anyone else.

Share this Article!

Hi, I'm Darian! I am a twenty-something insurance professional working on my ultimate quest for financial freedom. I hope you enjoyed this article. Stick around to learn more about financial strategies to manage debt, save more, spend less, and live the life you want.